THE ECONOMICS OF FIRMS AND INDUSTRIES
THE
EFFECTS OF MERGER ACTIVITY ON EXECUTIVE PAY
Mergers
lead to a doubling of the average compensation of the chief executive officers
(CEOs) concerned. But CEOs engaging in ‘bad’ - that is, wealth-reducing -
acquisitions experience significantly lower remuneration than their counterparts
whose deals meet with market approval. These are the central conclusions of new
research by Sourafel Girma, Steve
Thompson and Peter Wright,
presented at the Royal Economic Society’s Annual Conference on Wednesday 27
March. They suggest that shareholders have at least some success in penalising
managers for unwarranted empire-building.
A
common suggestion in the business and economics press is that mergers and
acquisitions are often motivated less by consideration of shareholder value and
more by the desire of a company’s CEO to increase the size of the firm. The
reason for this desire is obvious: managers of larger firms get paid more.
Although
clearly controversial, this view appears to be supported by empirical evidence
which suggests that the relationship between executive pay and firm size
dominates any that exists between executive pay and firm performance. What’s
more, merger activity appears, on average, to be detrimental to the shareholder
wealth of the acquiring firm. Growth by merger therefore appears to be a simple
strategy whereby senior executives can advance their own well-being, even if it
is at the cost of their own shareholders.
Girma,
Thompson and Wright consider this proposition for the UK by examining data for
the period 1981-96. They find some evidence to support this view. Mergers do
indeed lead to increases in remuneration, with mergers resulting in a doubling
of the average compensation of the CEOs concerned.
But
contrary to the conventional view, the quality of the merger also appears to be
an important factor. It is clear from the data that remuneration committees are
rewarding some managers for takeovers over and above increases in compensation
that would be expected purely from the increase in firm size. The extra pay
amounts to an additional 9% increase in salary.
This
view that shareholders make judgements about the quality of mergers is confirmed
when mergers are distinguished according to their impact on shareholder wealth.
CEOs engaging in ‘bad’ (that is, wealth-reducing) acquisitions experience
significantly lower remuneration than their counterparts whose deals meet with
market approval. This result suggests that shareholders have at least some
success in penalising managers for unwarranted empire-building, and CEOs are not
completely unfettered in this regard.
ENDS
Notes
for Editors:
‘Merger Activity and Executive Pay’ by Sourafel Girma, Steve Thompson and
Peter Wright was presented at the Royal Economic Society’s 2002 Annual
Conference at the University of Warwick.
Thompson is at the University of Leicester; Girma and Wright are in the School of Economics, University Park, University of Nottingham, Nottingham NG7 2RD.
For Further Information: contact Dr Peter Wright on 0115-951-5470 (fax: 0115-951-4159; email Peter.Wright@Nottingham.ac.uk; website: http://www.nottingham.ac.uk/economics/staff/details/peter_wright.html); or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).
WILL
PRIZE MONEY SAVE THE FA CUP?
As
part of an initiative to reverse the dramatic decline in attendance at FA Cup
matches, the FA has decided to introduce substantial prize money this season.
New research by Stefan Szymanski shows that the more widespread use of prizes as
incentives in team sports like football may have the potential not only to
ensure maximum commitment to the competition, but also to produce a more
balanced and therefore more attractive contest.
Szymanski
will present his findings at the Royal Economic Society’s Annual Conference
this week. The central intuition of his argument for the benefits of prize money
is that as long as teams are able to borrow, every team can borrow against the
possibility that they will win the prize. Therefore, everyone faces the same
incentive to invest.
It
is now widely accepted that the FA Cup is in decline. Over the last 30 years,
the trend has been a decline in attendance of 2% per year. Over the last decade,
League attendance increased by 27% despite significant price increases while FA
Cup attendance fell by 7%. As part of an initiative to reverse this decline, the
FA decided to introduce prize money this season ranging from £1,000 for victory
in the preliminary rounds to £2 million for the eventual winner.
Szymanski’s
research considers the usefulness of prize money in team sports and what effect
it has on the attractiveness of competition. The conventional approach to team
sports is that redistribution is necessary to ensure a competitive balance. This
justification has been used again and again by sports leagues to justify actions
that in any other industry would be deemed collusive and therefore illegal –
for example, restrictions on player mobility, salary caps and revenue sharing.
For example, this defence is being used by UEFA and was used by the Premier
League in the UK to defend collective selling of broadcast rights.
US economists have claimed that the ‘invariance principle’ applies - income
sharing neither enhances nor reduces competitive balance. But Szymanski shows
that this result depends on the nature of the player labour market. When a
single league dominates competition (as in the United States), the invariance
principle makes sense since all parties want to ensure that talent migrates to
its most valuable location, regardless of the extent of revenue sharing. (More
generally, this is an example of the Coase Theorem - that the distribution of
property rights should not affect the allocation of resources in a properly
functioning market).
But
when talent moves between rival leagues - as in Europe- Szymanski shows that
invariance no longer applies. His study shows that some kinds of revenue sharing
– for example, gate sharing where the visitors receive a fixed percentage of
the take - can make competitive balance worse since everyone wants the big teams
to be more successful and thus generate more income for sharing.
On
the other hand, when income is shared as a prize, competitive balance is
improved. The intuition is that as long as teams are able to borrow, every team
can borrow against the possibility that they will win the prize - and therefore
everyone faces the same incentive to invest. Prizes of this type are in fact
more common in Europe - not only the FA Cup but the Champions' League and
Premier League TV distribution formulas have significant prize elements - than
in the United States where equal sharing is the norm.
Szymanski concludes that the more widespread use of prizes as incentives - much
as they are used in individualistic sports like tennis and golf - may have the
potential not only to ensure maximum commitment to the competition, but also to
produce a more balanced and therefore more attractive contest.
ENDS
Notes
for Editors:
‘Competitive Balance and Income Redistribution in Team Sports’ by Stefan
Szymanski will be presented at the Royal Economic Society’s 2002 Annual
Conference at the University of Warwick on Wednesday 27 March.
Szymanski
is at Imperial College Management School, 53 Prince's Gate, Exhibition Road,
London SW7 2PG.
For
Further Information:
contact Stefan Szymanski on 020-7594-9107 (fax: 020-7823-7685; email: szy@ic.ac.uk); or RES Media
Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).
Recently,
governments in Western Europe and North America have developed new forms of
public-private partnership for public service provision. In particular, in the
UK, it has become common, under the PFI, to contract out the design, building,
finance and operation of an infrastructure project to a consortium of firms.
This
study examines whether it is preferable for the government to contract with a
consortium (as in the PFI model) or with separate firms for the building and the
operation of a facility. It also examines whether ownership of the facility
should reside with the private firm(s) or with the public sector.
In
some circumstances, there is a positive synergy across the stages of production.
For example, if greater costs are incurred in the design of a prison, it may be
cheaper to operate the prison at an adequate level of security. In this case, it
is preferable for the government to deal with a consortium of firms, as in PFI
model, for a consortium will invest so as to exploit the synergy.
But
it does not necessarily follow that the consortium should be given ownership of
the facility. Ownership by the consortium leads it to care more about the
residual value of the asset and the synergy across the stages, but less about
the effect of investment on social benefits. If the latter is significant, it
might be desirable to allow for more direct government control, which is better
achieved under government ownership. Otherwise, PFI is optimal.
Instead,
when greater investment in the building stage generates higher management costs,
it may be preferable for the government to contract with separate firms, making
the PFI model undesirable. Suppose, for example, that safety is a major issue,
as in the building of railway infrastructure. A high level of investment in new
safety features at the building stage may lead to substantial social benefits.
But this investment may call for relatively expensive, skilled labour, to
operate the safety features.
Under
these conditions, the case for PFI is weaker since a PFI consortium will be
excessively concerned with the higher management costs rather than the
associated safety benefits. What’s more, it may be optimal to give ownership
rights to the government, rather than giving decision-making power to a firm
whose activities could compromise safety. When safety is not a major
consideration or can be easily monitored, as with roads and bridges, the case
for PFI is stronger.
ENDS
Notes
for Editors:
‘Building and Managing Facilities for Public Services’ by John Bennett and
Elisabetta Iossa was presented at the Royal Economic Society’s 2002 Annual
Conference at the University of Warwick. The authors are at Brunel University.
For
Further Information:
contact John Bennett via email: John.Bennett@ux-mailhost.brunel.ac.uk;
or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095
(email: romesh@compuserve.com).
WHY NON-PROFIT FIRMS ARE MAINLY IN THE ‘CARING SECTORS’
-
AND WHY THEY MOTIVATE EMPLOYEES MORE EFFECTIVELY
In
the UK and the United States, over 90% of non-profit firms are found in the
‘caring sectors’ - social services, health, education and culture. New
research by Patrick Francois of
Tilburg University, presented at the Royal Economic Society’s Annual
Conference on Monday 25 March, explains why:
·
When employees care about the level of service provision or its quality,
they may be motivated to perform tasks beyond their strict job description.
·
But such care only motivates effort if workers believe it will have an
impact. In other words, workers are motivated to go further than strictly
required, only when what they does ‘matters’.
·
Since non-profit status means that management is not directly concerned
with profit or not answerable to owners with such concerns, it commits
management to a form of non-interference and ensures workers’ efforts
‘matter’.
·
Non-profit firms can thus motivate their work force in a way that
for-profit firms cannot match.
Francois’
study also establishes how non-profit and for-profit firms will behave in
sectors where they co-exist. It predicts that:
·
Non-profit firms will employ fewer supervisory resources than their
for-profit counterparts.
·
Non-profit firms will pay equivalent quality workers more, on average,
than for-profit firms.
·
Somewhat paradoxically, non-profit firms will obtain more ‘donated
labour’ effort from their workers than for-profit firms.
A
recent National Bureau of Economic Research working paper (Naci and Tekin, 2000)
uses an extraordinarily detailed data set for US child-care workers to provide
what they claim is the first direct test of ‘labour donations’. They report
that workers in non-profit firms do receive lower wages when they perceive that
their work ‘matters’ but not in for-profit firms, as consistent with the
second prediction.
The
study also finds, somewhat paradoxically, that non-profit workers of the same
experience and characteristics, are paid, on average, higher wages than their
for-profit counterparts, as consistent with the third prediction. These results
are not likely to be due to idiosyncratic features of the child-care industry,
as the raw data show similar patterns across a number of industries.
With
the move to increased private provision of previously public tasks, the
non-profit sector has grown steadily in most OECD countries over the last 20
years. It is important - in both predicting the direction of future changes and
in designing optimal regulation - to have a good theoretical understanding of
the advantages provided by the not-for-profit organisational form.
Existing
analyses of non-profit firms suggest their advantages arise when the details of
service provision and purchase are difficult to pin down in a contract. The idea
is that non-profit status commits a service provider to ‘soft incentives’,
which protects purchasers, donators or volunteers from expropriation efforts on
the provider’s part.
But
these analyses cannot adequately explain the observed sectoral breakdown of
non-profit firms, particularly their over-representation in ‘caring
sectors’. Why are non-profits not also widespread in the provision of
management, business consultancy or the myriad other business service sectors of
the economy where such contracting difficulties, and opportunities for
expropriation, are also common?
This
study presents an alternative analysis of non-profit firms based on employees’
own concern for service provision, which can explain this sectoral breakdown,
and which can also reconcile previously puzzling empirical comparisons between
non- and for-profit firms.
ENDS
Notes
for Editors:
‘Competing Non- and For-profit Firms in Caring Sectors’ by Patrick Francois
was presented at the Royal Economic Society’s 2002 Annual Conference at the
University of Warwick.
Francois
is at Tilburg University in the Netherlands.
For
Further Information:
contact Patrick Francois on +31-13-466-8003 (home: +31-10-477-9264; email: Francois@kub.nl);
or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095
(email: romesh@compuserve.com).
A
desire to avoid controversy and protect their professional reputations makes
regulators too lenient on their industries, especially if they are on relatively
short fixed-term contracts. That is the central conclusion of new research by Clare
Leaver, presented at the Royal Economic Society’s Annual Conference on
Tuesday 26 March.
Her
findings suggest that short regulatory contracts may not be the panacea that
some have hoped for to deal with the threat of ‘regulatory capture’. Closing
the 'revolving door' between public office and industry employment may not be
enough to limit the inefficiencies created by regulatory career concerns.
Rather, governments may need to appoint their regulators on longer, if not
permanent, contracts.
The
role of industry regulator is becoming an increasingly high profile job. Policy
changes rarely pass unnoticed by the media and perceived mistakes create
substantial controversy. This study investigates whether the threat of
controversy biases the behaviour of industry regulators? The findings suggest
that regulators engage in ‘minimal squawk’ behaviour: adopting policies that
cause the least complaints from regulated firms.
To
date, regulatory appointments have been driven by other considerations. In
particular, the spectre of regulatory capture - over-familiarity resulting in
policies that favour the industry - has lead to the use of short
fixed-term contracts. Yet short contracts raise the significance of maintaining
a favourable reputation and are therefore more conducive to minimal squawk
behaviour.
Accordingly,
Leaver argues that governments are running the risk of replacing regulatory
capture with minimal squawk behaviour. To quantify this effect, she analyses
evidence from the regulation of the US electric industry. The results suggest
that short contracts may actually be creating greater
inefficiencies than they were designed to replace.
It
is often easy to observe whether a regulator has chosen a 'generous' policy
(such as a low price cap) or a 'tough' one (such as a high price cap). But
without further knowledge of market conditions it is harder to evaluate the quality
of this decision (for example, a low price cap might be optimal in light of
rising fuel costs or new environmental directives). If in addition, regulators
differ in their ability to make good decisions and this private information is
relevant to potential future employers of regulators, these factors combine to
ensure that short contracts result in socially sub-optimal policies.
Suppose
a regulated firm squawks when its regulator makes a mistake that is not in its
favour (for example, the regulator sets a high price cap when the firm faces
high costs), but keeps quiet when the decision is its interest, whether mistaken
or not (for example, the regulator sets a low price cap). As long as potential
employers believe able regulators are trying to make good decisions, bad
decisions are indicative of low ability. Realising that 'tough' policies expose
their poor decision-making to public scrutiny, less able regulators therefore
have an incentive to set 'generous' policies, even when there is evidence to
suggest that 'tough' policies are socially optimal.
Applying
this logic, Leaver shows that the shorter the contract (that is, the greater the
need to maintain a favourable reputation), the greater the frequency of
'generous' regulatory policies. Given regulatory terms of office vary widely
across US states, she tests this prediction using data from the regulation of
the US electric industry.
Equating
minimal squawk behaviour with failing to initiate rate reviews, the analysis
predicts that rate reviews should be less likely, and prices should be higher,
the shorter the statutory term of office. There is strong evidence in favour of
both hypotheses. Firms are significantly less likely to face a rate review when
their regulators serve for shorter terms, while an extra statutory year of
office reduces residential electricity bills by 0.1 cents per kwh.
ENDS
Notes
for Editors:
‘Bureaucratic Minimal Squawk: Theory and Evidence’ by Clare Leaver was
presented at the Royal Economic Society’s 2002 Annual Conference at the
University of Warwick.
Leaver
is at University College London.
For
Further Information:
contact Clare Leaver on 020-7679-5897 (mobile: 07787-526813; email: clare.leaver@ucl.ac.uk);
or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095
(email: romesh@compuserve.com).
THE
UNPREDICTABLE IMPACT OF FOREIGN DIRECT INVESTMENT
ON
DOMESTIC PRODUCTIVITY IN THE UK
Governments
the world over view foreign direct investment (FDI) in a largely positive light
because of the potential productivity benefits that it promises – through
enhanced competition, increased demand for local resources and by the best
practice and latest technology of foreign-owned firms ‘spilling over’ to
domestic firms.
But
new research by Richard Harris and Catherine
Robinson, presented at the Royal Economic Society’s Annual Conference on
Monday 25 March, raises important questions about these ‘spillovers’. Their
analysis of 20 UK manufacturing industries - including motor vehicles and their
parts, chemicals, aerospace and pharmaceutical products – reveals no clear
pattern of benefits for domestic firms from the presence of foreign-owned firms.
Indeed, spillovers are as likely to be negative as positive.
FDI
in UK manufacturing has increased from around 14% in 1974 to almost a third of
sales by 1997. And, as elsewhere in the world, the increase has been largely
supported - indeed encouraged - by the UK government. Foreign-owned firms are
expected to bring productivity increases from direct and indirect sources: by
the healthy injection of competition; from the increased demand for local
capital and labour resources; and indirectly, by their best practice and latest
technology spilling over to domestic firms. Indeed, the motivation of a number
of regional and industrial policies has been to attract foreign investment
because of the productivity improvements that they are supposed to generate at
the local, industrial and national level.
Until
recently, it has not been possible to look at productivity at such a
disaggregated level. But access has now been granted to the ARD (Annual
Respondents Database), the micro data that underlies the Census of Production (ONS):
14-19,000 establishments surveyed every year for primarily financial data and
weighted to reflect the whole of the manufacturing sector. Each plant has a
unique identifier and may be linked over time, so that it has been possible to
look at productivity changes and differences over time at the plant level.
Harris
and Robinson’s study measures spillovers from FDI to domestic firms from three
directions: from being located in the same region as a concentration of foreign
firms; from being in the same industry as a concentration of foreign firms; and
finally from being in the same supply chain as a concentration of foreign firms
- agglomeration, intra and inter spillovers, respectively. The research looks at
total factor productivity changes over time in 20 different industries with a
significant foreign presence.
The
results indicate that spillovers are not always positive; indeed, they are as
likely to be negative as positive. There is no clear pattern across the 20
industries, which include motor vehicles and their parts, chemicals, aerospace
and pharmaceutical products. Thus, policies that encourage inward investment on
the assumption that spillover benefits will automatically accrue to local plants
are misguided.
That
said, the authors are critical of the methodological approaches so far developed
for failing to capture the true relationship and the potential for synergies
between the foreign-owned firm and the domestic plant.
ENDS
Notes
for Editors:
‘‘Productivity Spillovers to Domestic Plants from Foreign Direct Investment:
Evidence from UK Manufacturing, 1974-95’ by Richard Harris and Catherine
Robinson was presented at the Royal Economic Society’s 2002 Annual Conference
at the University of Warwick.
The
study was presented at a special session of the conference on ‘Foreign Direct
Investment and the Productivity Gap in the UK’, organised by the Leverhulme
Centre for Research on Globalisation and Economic Policy at the University of
Nottingham.
The
other studies presented were ‘FDI Spillovers and the Role of Absorptive
Capacity’ by Sourafel Girma and Holger Görg, and ‘Foreign Ownership and
Technological Convergence at the Micro Level’ by Rachel Griffith, Stephen
Redding and Helen Simpson. The papers were discussed by Christopher Moir of the
Department of Trade and Industry.
Richard
Harris is in the Department of Economics and Finance, University of Durham,
23-26 Old Elvet, Durham; Catherine Robinson is in the Department of Economics,
University of Portsmouth, Locksway Road, Southsea.
For
Further Information:
contact Richard Harris on 0191-374-7280 (email: Richard.harris@durham.ac.uk(;
Catherine Robinson on 02392-844017 (email: kate.robinson@port.ac.uk);
or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095
(email: romesh@compuserve.com).
‘FOOTLOOSE’
MULTINATIONALS?
Recent
high-profile plant closures and job-cuttings by multinational companies have
refuelled the criticism that these firms are highly ‘footloose’, quick to
shift their production facilities from one country to another if the current
economic environment changes to their disadvantage. One recent example is the US
car manufacturer Ford, which announced the end of car assembly at its Dagenham
plant near London, leading to 1,100 job losses, as well as 1,400 jobs lost at
its plant in Genk, Belgium as part of a strategy of restructuring European
operations.
But
new research by Holger Görg and Eric
Strobl, presented at the Royal Economic Society’s Annual Conference on
Tuesday 26 March, suggests that the argument is not as clear-cut as critics of
multinationals make it seem. While a comparison of foreign multinationals and
domestic plants shows that the former are about 40% more likely to exit an
industry than comparable domestic plants, new jobs created in multinationals are
about 10% more likely to survive than jobs created in similar domestic plants.
Görg
and Strobl investigate the claim that affiliates of multinational companies are
more footloose than domestic plants by focusing on two different facets of the
issue: plant survival as well as the persistence of newly created jobs in a
plant over time. Their study looks at manufacturing plants in the Republic of
Ireland, where foreign multinationals account for about half of manufacturing
employment, three-quarters of net output produced, and over 80% of manufacturing
exports.
Estimating
the determinants of plant survival, Görg and Strobl find that plants belonging
to multinationals located in Ireland have lower survival rates than comparable
domestic plants - about 40% lower. In addition, foreign plants react differently
to changes in some of the factors determining survival, such as plant size or
sectoral conditions. Taken together, this may be interpreted as evidence that
multinationals are more footloose than comparable domestic plants.
It
is a different question, however, as to whether this higher probability of
exiting also means that employment in multinationals is more unstable than
employment in domestic plants. Focusing only on continuing plants, these
researchers analyse the factors that determine whether employment changes at the
plant level persist over time. Estimating the determinants of the survival of
new jobs created in foreign and domestic plants, they find that jobs created in
the former are more likely to persist (by about 10%) than those created by
similar domestic firms. This result does not lend support to the claim that
employment in multinationals is more unstable than in domestic plants.
These
results suggest that employment decisions in multinationals are made with a
longer time horizon in mind than in domestic plants. Multinationals seem to be
more likely to create new jobs only if they expect those jobs to last in the
long run while domestic plants base job creation decisions more on a short-term
basis.
ENDS
Notes
for Editors:
’”Footloose” Multinationals?’ by Holger Görg and Eric Strobl was
presented at the Royal Economic Society’s 2002 Annual Conference at the
University of Warwick.
Görg
is at the Leverhulme Centre for Research on Globalisation and Economic Policy in
the School of Economics at the University of Nottingham; Strobl is in the
Department of Economics at University College Dublin
For
Further Information:
contact Holger Görg on 0115-846-6393 or 0115-951-5469 (fax: 0115-951-4159;
email: Holger.Gorg@nottingham.ac.uk; website:
http://www.nottingham.ac.uk/economics/staff/details/holger_gorg.html);
or RES Media Consultant Romesh Vaitilingam
on 0117-983-9770 or 07768-661095 (email: romesh@compuserve.com).
MACROECONOMIC
INSTABILITY KILLS!
THE
DANGERS OF BUSINESS
FAILURE FOR LARGE UK FIRMS
Macroeconomic
instability, such as exchange rate volatility and surges in inflation, has a
significant detrimental impact on quoted firms in the UK, leading in many cases
to bankruptcy or acquisition, particularly for newly listed firms. That is the
central conclusion of new research by Arnab
Bhattacharjee, Chris Higson, Sean
Holly and Paul Kattuman, which
was presented at the Royal Economic Society’s Annual Conference on Wednesday
27 March.
We
often hear of the importance of macroeconomic stability. But what is the
evidence? The study examines this question for one particular aspect of
corporate performance, or rather, non-performance: business failure through
bankruptcy or acquisition by another firm.
Bankruptcies
are dramatic and painful episodes that take place against the continuous
background process of restructuring in modern economies. Firms at risk of going
bankrupt may also be acquired, and this may help in the efficient redeployment
of their assets. These two major forms of restructuring are in an essential
sense competing with each other to be the correction mode; though of course,
firms performing well may also be targets of takeover.
Bankruptcies
are generally associated with recessions and acquisitions with recoveries. Using
data on about 4,300 listed UK companies over the period 1965-98, these
researchers identified 1,859 mergers and 166 bankruptcies. The rate of mergers
rose on the upturn, from 1975 to 1978, and then again from 1982 to 1986.
Interestingly, the rate at which companies at risk of bankruptcy stopped
publishing financial accounts was highest in 1980 and 1989, at the earliest
stages of economic downturns.
But
beyond the macroeconomic cycle, what is the influence of macroeconomic
instability, for example, of exchange rate and inflation volatility? The
research finds clear evidence than instability is detrimental. Newly listed
companies are more likely to go bankrupt during years when the pound sterling
depreciates sharply. While a weaker currency aids survival, macroeconomic
volatility ‘kills’! Uncertainty in the form of sharp increases in inflation
also makes freshly listed firms more prone to go bankrupt. Acquisition activity
is subdued in such years and offers little ‘competition’ to bankruptcy.
There
are notable differences in the way in which recently listed firms, and those
that have been listed for some years, respond to changes in the macroeconomic
environment. Firms that have been listed during the upturn have a higher
propensity to go bankrupt as soon as the economy turns down. Firms that have
weathered the downturn after listing and in that sense proven themselves
‘capable’, are more likely to be acquired immediately after the economy
enters the up phase. The acquisition probability is boosted if the firm is also
cash-rich, and is neither too large nor too small.
ENDS
Notes for Editors:
‘Macroeconomic Instability and Business Exit:
Determinants of Failures and Acquisitions of Large UK Firms’
by Arnab Bhattacharjee, Chris Higson, Sean Holly, Paul Kattuman was presented at
the Royal Economic Society’s 2002 Annual Conference at the University of
Warwick.
The
paper is part of a research programme on ‘Business Failure, Business
Organisation and Macroeconomic Instability’ conducted jointly at the
Department of Applied Economics and the ESRC Centre for Business Research at the
University of Cambridge, and sponsored by the Leverhulme Trust under grant
number F/778/A.
For
Further Information:
contact Paul Kattuman on 01223-335259 (email: Paul.Kattuman@econ.cam.ac.uk);
or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or
07768-661095 (email: romesh@compuserve.com).
IN WHICH INDUSTRIES DO FIRMS FACE THE BIGGEST THREATS
TO
THEIR SURVIVAL?
What are the key factors in an industry that cause a high turnover of firms, particularly among smaller firms? Vivek Ghosal has analysed an extensive new database covering 267 US manufacturing industries over a 30-year period to answer this question. The research, which was presented at the Royal Economic Society’s Annual Conference on Tuesday 26 March, shows that:
·
The turnover of firms is higher when there is greater uncertainty about
profits along with high sunk costs of capital investments.
·
Greater uncertainty almost entirely affects the relatively smaller firms,
leaving the larger firms unscathed. The typical industry in the sample has about
558 firms. The results show that a 50% increase in profit uncertainty results in
a decrease of about 45 (smaller) firms in the industry. This is a relatively
large quantitative effect.
·
Technological progress - or productivity growth – also contributes to
firm turnover: a 50% increase in productivity growth results in a decrease of
about six firms.
·
Overall, profit uncertainty appears to be a more important determinant of
the turnover of smaller firms than productivity growth. The results suggest that
greater uncertainty about profits exacerbates the financing constraints faced by
the relatively smaller firms, resulting in their lower survival probabilities
and causing greater exits.
These
findings on profit uncertainty and sunk costs could be useful in several areas:
·
First, they provide guidance for competition policy. The results suggest
that profit uncertainty compounds the sunk cost barriers, lowers the probability
of survival of smaller incumbents and retards entry. This implies that mergers,
for example, ought to receive closer scrutiny in markets with greater
uncertainty.
·
Second, evaluating the determinants of merger and acquisition (M&A)
activity has long been an important area of research. Since uncertainty reduces
the probability of survival, it has implications for the reallocation of
capital: for example, do the assets exit the industry or are they reallocated to
other firms within the industry via M&A? The findings suggest that profit
uncertainty in combination with sunk costs may explain part of M&A waves.
·
Third, since entry and exit reflect the bigger picture of economic
activity, the results imply that uncertainty and sunk costs help to explain job
creation and destruction, and variations in investment spending.
·
Finally, the results could provide insights into the evolution of
specific industries: for example, the electricity industry is undergoing
deregulation and there are numerous mergers involving firms of different sizes.
These findings could be used to predict a future path that leads to weeding out
of smaller firms and greater industry concentration.
ENDS
Notes
for Editors:
‘Impact of Uncertainty and Sunk Costs on Firm Survival and Industry
Dynamics’ by Vivek Ghosal was presented at the Royal Economic Society’s 2002
Annual Conference at the University of Warwick.
Ghosal is at the School of Economics, Georgia Institute of Technology, Atlanta, GA 30332.
For
Further Information:
contact Vivek Ghosal via email: Vivek.Ghosal@econ.gatech.edu;
or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or 07768-661095
(email: romesh@compuserve.com).
WHICH
FIRMS ARE MOST SUSCEPTIBLE
TO
RECESSIONS AND RECOVERIES?
While
no firm is immune to the business cycle, firms that have been either growing
rapidly or declining rapidly are far less sensitive to overall movements in the
economy than the mass of firms growing at medium rates. That is the central
conclusion of new research by Chris Higson, Sean Holly,
Paul Kattuman and Stelianos
Platis, presented at the Royal Economic Society’s Annual Conference on
Monday 25 March.
The
study analyses the accounts of all UK companies listed on the stock market for
the period 1968-97 to assess which firms are most susceptible to recessions and
recoveries. The research reveals that among the most ‘vulnerable’ in terms
of growth are neither the young nor the small, but firms in the middle range of
growth itself. The pattern, which is corroborated for US companies, shows that:
·
With an economic upturn, firms growing at lower medium rates speed up and
move closer in their rate of growth to rapidly growing firms and away from the
stragglers.
·
In an economic downturn, these firms slow down relative to high growth
firms and move closer to those in the left ‘tail’ of the growth rate
distribution.
·
Specifically, firms that lie in the 25th to the 50th percentiles, when
ordered by growth rates, are most responsive to overall upturns and downturns.
These firms respond to GDP growth at rates that are three to five times higher
than firms in the ‘tails’ of the growth rate distribution.
·
The growth effects of firm size, firm age and industry of the firm do not
show much variation over the business cycle, and do not explain observed
patterns in the dynamics of the growth rate distribution.
To
analysts of the growth of firms, these findings suggest the importance of
designing policies with due consideration given to ‘nonlinear’ responses of
firms to macroeconomic growth.
To
policy-makers concerned with business cycles, the finding of differential
responsiveness to aggregate economic movements suggests a clear focus on low
medium growth firms, more than merely the small or the young.
ENDS
Notes
for Editors:
‘The Business Cycle, Macroeconomic Shocks and the Cross Section: The Growth of
UK Quoted Companies’ by Chris Higson, Sean Holly, Paul Kattuman and Stelianos
Platis was presented at the Royal Economic Society’s 2002 Annual Conference at
the University of Warwick.
The
paper is part of a research programme on ‘Business Failure, Business
Organisation and Macroeconomic Instability’ conducted jointly at the
Department of Applied Economics and the ESRC Centre for Business Research at the
University of Cambridge, and sponsored by the Leverhulme Trust under grant
number F/778/A.
For
Further Information:
contact Paul Kattuman on 01223-335259 (email: Paul.Kattuman@econ.cam.ac.uk);
or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or
07768-661095 (email: romesh@compuserve.com).
PROFITABILITY,
UNCERTAINTY AND NEW CAPITAL INVESTMENT
Investment
in physical capacity – plant, machinery and new buildings – is a key
indicator of future prosperity, but despite its undoubted importance in wealth
generation, investment in the UK and continental Europe has been flagging in
recent years. Hopes for a recovery are founded on the perceived benefits of
increased macroeconomic stability and a consequent decline in business
uncertainty, but new research by Ciaran Driver, Paul Temple
and Giovanni Urga, suggests this view
may be misguided.
Their
findings, which were presented at the Royal Economic Society’s Annual
Conference on Tuesday 26 March, answer several key questions about the
determinants of capital investment:
·
What is the role of uncertainty? Unfortunately for those who place faith
in the restorative powers of macroeconomic stability, macroeconomic uncertainty
affects the timing of investment rather than its level.
·
Is finance a problem for UK manufacturers? There is no evidence for the
existence of a ‘finance gap’ preventing UK manufacturers from investing more
heavily. Nor do tax changes appear to cause dramatic effects - with the possible
exception of the Lawson changes in the mid-1980s.
·
What ultimately drives investment? Rather than uncertainty or finance,
the constraints on investment have come from managers imposing high required
rates of return on capital projects. Long-run profitability and capacity
utilisation are key determinants of investment.
·
Why does investment in plant and machinery behave differently to
investment in buildings? Building responds more powerfully to profitability than
plant and machinery, but nevertheless has languished for other reasons. One
possibility here is that technological change or changes in industrial
composition may have biased investment away from new building assets.
·
Why has building investment generally trended downwards? The researchers
speculate that the switch away from new building may be due to increased
shareholder activism and tightening corporate governance, which has created
pressure on managers to orient investment towards quickly achieved goals.
Investment
in physical capacity in manufacturing is thought to be particularly important
for future prosperity because of the greater scope for productivity advance in
that sector. But this is likely to depend on the ability of investment to
generate new firm entry and more competition. Manufacturing investment has been
associated with beneficial spillover effects on other sectors of the economy.
Can
European economies confidently expect an investment-led growth phase as we
appear to move into a low inflation and less cyclical environment? Many
economists – particularly in the United States - have tended to assume that
the level of investment is understood pretty well and that only the short-term
timing of investment remains as a problem to be explained.
This
study takes issue with that and demonstrates that the standard model of
investment is quite inadequate in its ability to explain capital investment in
UK manufacturing. It shows that a model that takes care to distinguish between
different classes of capital asset, and which focuses on the roles of long-run
profitability and capacity utilisation, provides a robust predictor of
manufacturing investment in the UK.
ENDS
Notes
for Editors:
‘Profitability, Capacity and Uncertainty: A Robust Model of UK Manufacturing
Investment’ by Ciaran Driver, Paul Temple and Giovanni Urga was presented at
the Royal Economic Society’s 2002 Annual Conference at the University of
Warwick.
Driver
is at Imperial College Management School, University of London SW7 2PG; Temple
is in the Department of Economics, University of Surrey, Guildford, Surrey GU2
7XH; Urga is in the Faculty of Finance, City University Business School,
Barbican Centre, London EC2Y 8HB.
The
research was funded by the Economic and Social Research Council (ESRC).
Last updated
12th April 2002